Trading the News

CHAPTER 4

In February 1999 Futures magazine’s front-page story was titled “Code Blue for Crude, How Low Can Prices Go?” After crude dropped from $27 to under $10 in less than 2 years, they predicted that the market would stay in its dismal state. They stated that the market was suffering from oversupply, no demand, OPEC’s failure to reach a consensus on production cutbacks, and the warm weather due to El Niño. The “experts” did not foresee the market moving much higher any time soon. Well look at Chart 4–1 and see what happened; the article pretty much pinpointed the bottom of the bear market in crude. Immediately afterward, it exploded with an almost $30 up move to its highest levels in 10 years, surpassed only by the price of oil during the time leading up to the Gulf War. The moral here is to be wary of what you read and hear; a major news event or story may just be the signal that the smart money was waiting for to get out and end the move.

THE FUNDAMENTALISTS VERSUS THE TECHNICALISTS There are basically two schools of traders: the technical analysts who trade off charts and the fundamental analysts who trade off the news and the underlying conditions of the market. There is also a middle ground where traders use both, but those traders are basically technicalists or fundamentalists who use the other source to

CHART 4—1

Monthly Crude: Calling the Bottom

confirm a belief. Atechnical trader can use fundamentals when evaluating market conditions or to see if overall market sentiment has shifted. For the most part, I’m a staunch believer in using technical analysis as the main method of trading, but I still think it’s important to know why the market is doing what it is doing. A change in underlying conditions can alter a market’s direction, and it is important to be aware of it.

Fundamental traders tend to be long-term traders who are looking for major economic shifts in a market. They use fundamentals to determine what the overall direction of the market should be, not to jump into trades. Some are short-term traders who believe that every move in the market is based on the smallest news item relating to it. But most moves in a stock are not a result of earnings expectations, and not every move in the grain market is a direct result of the latest change in the weather forecast. If a person were to base all trading decisions on what he read or heard, odds are, that person would be a losing trader. Learning from experience that the market doesn’t always do what it should do,

many professionals pay little heed to the actual news when trading. Instead they are more concerned with how the market reacts to the news. Many times when the market doesn’t react as it should, they may be more inclined to fade a news story rather than trade in the direction it suggests the market should go. I find that some of the highest probability trades come when fading the news, as I’ll explain later in this chapter.

IF YOU KNOW IT, YOU’RE PROBABLY NOT THE FIRST For the most part, novice traders use the news incorrectly: Many read an article in the Wall Street Journal and barrel into a trade, not realizing that the news was discounted in the market days or weeks earlier. They forget that top trading firms have departments whose job it is to know exactly what is going on with any given stock or market before it becomes general knowledge. They have their own meteorologists who have determined the long-term weather report before the average trader gets it on the Internet. They have economists and analysts who are always trying to be one step ahead of everyone else. More important, they can get to the source of the news before anyone else can. Think about it: Most of the time when the public gets information, it has to hear or read a news story somewhere. That means that someone already knows it. For if you see a story on Reuters, the reporter had to type it in first, and so he had to know it before you; that means he got it from someone else who knew it before he did. What makes you think that the chain is that short? The story easily could have found its way to a trading desk at Goldman Sachs by the time it reached the reporter, and by the time he reports it and you hear it, a trader at Goldman could have reacted already.

Once the public gets hold of news, it is probably not fresh anymore, and it may have already been taken advantage of. Many times you will see the market react first and wonder why it did so, only to hear the news a little later; by this time it may be too late to do anything, and the best thing to do is to ignore it completely. Never chase a news-related spike. Let the market settle down first and digest the news. If you miss the trade, there will always be another one. If you happen to be in it already, don’t get excited or panic. Again, let the market settle down before doing anything.

Example of How the Public Is the Last to Know Agreat example of how the average trader is the last to know something and of how once people do know, it has already been factored into the price, happened to me recently while I was trading the stock Rambus (RMBS) (Chart 4–2). Luckily, I was on the right side of this move. I was short in the stock, and then all of a sudden it dropped hard, as if it had fallen off a table. The stock market in general had opened sharply lower that morning because of bad unemployment numbers (see Chart 4–3) but had been ripping higher all day long after that. I had mostly long positions, but to balance such positions I like to find some stocks that are reacting weakly in a strong market. Rambus was one of those; it was not able to uptrend and stay positive on a day when most stocks were going much higher. There was obviously something wrong with it. I didn’t know what, and I didn’t care. RMBS appeared on my screen as a relatively weak stock. Looking at a chart, I saw that it was not as strong as everything else, and so I shorted it at around 1 p.m. It didn’t go anywhere, but I thought that if the market failed, it would probably drop, so it was a good short to have. Then, all of a sudden, at 2:30 the bottom fell out of it and I had no idea why; in the next 12 minutes it dropped about $3. I knew it had to be news-related, because a stock does not fall like

CHART 4–2

1-Minute RMBS: Making a Move before the News Is Out

CHART 4–3

5-Minute S&P 500: A Strong Day after Bad News

this otherwise, though I hadn’t heard anything. Then NASDAQ halted it because of news pending, and it didn’t trade for an hour as the market waited for the news to be announced. Finally, at 3:40, news was released that a judge had thrown out a patent infringement case that Rambus had filed against its competitor Infineon Technologies AG, and it resumed trading.

Immediately after it resumed trading, it was down another buck fifty. I placed a market order to get out because more times than not after a news item is known, things have a tendency to trade opposite to their initial reaction; besides, I had made a nice profit in it. When a stock drops before an announcement and then opens up even lower, it is common to see people take profits and for it to trade back up. I placed my order to get out immediately after it opened, and apparently I wasn’t the only one to do so, as it ran up so fast that I got filled about a dollar higher from where I placed my order. Then, sure enough, it went right back down after I got out. I did the right thing by getting out because it was rallying and I thought it would shake off the bad news and go right back up to retrace the drop.

Looking at this example, one can see that some people had to know in advance about the pending news release: They started to unload and/or short the stock way before it was halted and an hour and half before any news came out. By the time the public got the information, it already had dropped $3. So how do some traders have a head up on the news? Why were some people able to react before the trading was halted? The reason could be that institutions have direct access to important personnel and information in the companies they make a market for. If a major court decision is about to come out, they may be on the phone all day with someone at the company. Whether this is the reason or not, what’s important is that by the time the general public got hold of it, the big players already had acted on it. It fell 20 percent on the day, but most of that came before the news was made public. Unless one knew beforehand, there was no way to act on it.

BUY THE RUMOR AND SELL THE FACT The problem with news-related trading is that most people don’t know what to do with it. I’ve seen too many traders hear some news, see a quick burst in price, and jump in, not wanting to miss the boat. The next thing they realize is that they just bought the high of the market as they watch it dip hard. If you’ve been around trading a little while, you’ve probably heard the expression “Buy the rumor, sell the fact.” The most effective traders respond by watching price action and then fading a news story. They know that the news has already been factored into the current price of the market, and once the market gets what it was expecting, the anticipation is gone. With the anticipation gone, people take their profits and get out, causing the market to reverse. It’s before the news comes out that the market makes its move; afterward there is no advantage anymore, and so the smart money gets out.

IF IT SHOULD GO LOWER BUT DOESN’T, IT’S GOING HIGHER The news doesn’t really matter. What is important is the other traders’ aggregate position and what they are expecting when the news comes out. As soon as news comes out, the smart traders look to see how the market reacts and what the other traders are doing.

Arule of thumb for when news comes out that should affect a stock or commodity is that if it is bad news and the market shakes it off and rallies, this is a bullish reaction to the news, so buy it. It probably means that the market has already discounted the news. On the flip side, if good news comes out and your stock or commodity fails to rally, the high probability trade is to short it. It’s more important to see how the market reacts to the news than to know what the news is. Experienced traders look to see what happens after a news item comes out, and then they react accordingly. They hope to see a market fail to react the way it should have and then fade the news. The more anticipated the news is to be positive or negative, the more likely it is that it will be potentially disastrous to trade on the side of the report. If the market was expecting good news, it may have run up accordingly before getting it so that the market is priced with the news taken into consideration. Many times the reason for the market to end its move when news comes out is that traders were already long in anticipation of news, a rate cut, or a heat wave, and then the event or news does come out as expected. Once it comes out, the market may fail to continue because it may be saturated with longs and there is no one left to buy. As the final suckers rush into the market, the smart money sees it as an opportunity to take profits. When the news does make the market react the way it should, the best thing to do is to wait for it to settle and then get in on the right side. If you jump into it early, there is always a good chance that you may get caught in a retracement or spike.

The same morning that the RMBS situation happened, the monthly unemployment numbers were released, and it was the biggest jump in new claims in a decade. The market reacted to this bad news by opening a lot lower; the Dow was quickly down over 100 points, and the S&Ps about 20 (Chart 4–3). But before long the market wouldn’t go much lower, and by 10 a.m. it started to rally. By the end of the day the Dow was up 148,and the S&Ps were up 18. This was a great example of how to trade news. The news was bad and the market couldn’t go lower, and so buying was the right play. Looking at the chart, you can see how the S&Ps opened down 17 points and then went down a little more. After the first half hour, however, it could not break lower and began to rally. Whenever news comes out that causes an extreme move in a market’s open, if it cannot follow through, the best way to trade that

market is to fade the news. As you can see, the market tried to go lower but failed and then broke highs. This meant that the market overreacted to the news but then took it in stride and decided it wasn’t important enough to make the market go down. At that point people started covering their shorts and going long. It also was the case in this situation that bad news was good news as people started thinking that the weakening economy would encourage the Federal Reserve to cut interest rates again.

IS IT GOOD NEWS OR BAD NEWS? What defines good news is often subjective and hard to determine because good economic news can be counterproductive to getting the Fed to cut rates. It seems that the Fed’s reaction to every piece of news that comes out is more important than the news. Traders need to be alert to a situation such as the bad unemployment data described above. Yes, it’s bad for the economy, but if the economy gets worse, the Fed may cut rates, or at least not raise them, and that will make the market rally. There are also many times when a company announces that it will be laying off people. This sounds like bad news for the company, but many see it as a cost-cutting method and thus a way for the company to improve its bottom line down the road. This type of news can make a stock rally even though one would perceive it as negative news.

THE MARKET WILL DO WHAT IT WANTS TO DO Many times unexpected news may come out that is the opposite of what the market has been doing. Initially the response is a rapid, hard move the other way, but once traders take a deep breath and reevaluate, the market normally will continue in its set trend. I can’t count how many times a downtrending stock reports better than expected earnings, has a quick bounce, and then spirals back downward. The news isn’t important here; it is more important to see how the market reacts to it after the initial move. Fundamentals should be believed only as long as the technical signals agree. Too many times a trader will stick with a news story and not let go no matter what the market ends up doing. Opinions mean nothing to the market; the market goes where it wants to, not where you think

it should go. If the market shakes off news and continues its trend, a trader should ignore the news and follow the market.

UNEXPECTED VERSUS EXPECTED NEWS EVENTS Look at how the market reacted to the unexpected rate cut by the Fed on January 3, 2001 (Chart 4–4). After being in a huge downtrend for weeks, the market exploded upon hearing this unexpectedly good news. I happened to have had one of my worst days ever that day, as I had gotten heavily short 30 minutes before the cut and ended up losing $5 to $10 per share on stocks I had just shorted. The unexpected cut drove the market straight up, and the S&Ps rallied some 70 points by the end of the day. Yet the facts were that the economy was weak, and by cutting rates unexpectedly, the Fed acknowledged this. The next few days, as people came to their senses and the initial euphoria of the cut wore off, the market backed off and began to continue the downtrend it had been in. It took a few more days for people to begin expecting the Fed to cut rates again at the next Open Market Committee meeting on January 31,and this caused the market to start drifting up in anticipation. On January 31, the Fed cut

CHART 4–4

Daily S&P 500:Unexpected and Expected Rate Cuts

rates again, but this time it was expected and the market didn’t react with a pop. Instead, it immediately sold off, marking the top of the upwave that had been created soon after the initial cut. It’s funny how the market reacted to the same news on two different occasions. The news was the same—the Fed cut the discount rate by 50 basis points—yet one time the market had an intraday explosion and the second time it failed miserably. Why? Because the second time it was expected that the Fed would make a cut after its meeting, and the market had rallied for weeks on that expectation. As soon as the market got what it wanted, there was nothing more to look forward to. In this case the smart money says thanks and gets out as it “buys the rumor and sells the news.”

GETTING THE MOST OUT OF THE FUNDAMENTALS Get the Whole Picture If you are going to trade on the basis of news, do it right and get the whole picture, not just a piece of it. If you are buying soybeans because you heard about massive floods that were expected to kill crops and thus lift prices, don’t forget that the Midwest is not the only place where beans are planted. How are crops in Argentina doing? What about Europe—can they take up the slack? What is worldwide demand? Are there are stockpiles? Sure, the weather will affect the crops, but don’t expect the market to explode just because of that; everything else has to be in sync as well. If you plan to trade effectively using fundamental analysis, you need to look at the overall picture of any news involving the market. Alazy trader may get only a piece of the puzzle.

For example, when trading crude, one may want to know what the current productions levels are, where stockpiles stand and how they compare to previous months, what OPEC is doing (increasing production or cutting back), and the weather. All these things affect the overall picture of the market and can give you a general direction in which the market should be heading. For example, if stockpiles are high, production is expected to stay strong, and the winter is expected to be warm, you can assume that prices will keep going lower, and so you would want to trade the market from the short side.

In trading stocks, besides knowing everything about the company, you need to know what is going on with the market and the economy in general. How is the sector? How are retail sales? How is consumer confidence? Are interest rates going up or down? Has the gross domestic product been in an uptrend? What is the unemployment situation? All these things will help a trader, but one shouldn’t dwell on every little news release that comes out. I just like to know these things so that I can have a general idea of what the stock and market should be doing.

Trading Scheduled News Releases The most important thing a high probability trader wants to do before a scheduled news release is to be flat. The market can go either way when a report comes out, and by having a position you are adding too much risk to your trading. It’s not worth trying to guess which way the market will go after a report comes out. When a trader starts doing this, he becomes a gambler, not a trader. This mostly applies to short-term traders, as I don’t believe one report will make much difference in the price of a stock in the long term.

The way I like to trade a scheduled report is by looking at how the market reacts just a few minutes before the release of scheduled news. Whichever direction it’s moving in is what the consensus is thinking. If the number is in line with expectations, this is the direction the market should move, and any surprises may cause it to go the other way. If the market cannot continue in the direction it had been moving and the news was as expected, the best thing to do is to fade it because it just failed to react according to what it should have done.

Many times the initial response after the announcement is a spike upward which quickly retraces, sometimes to keep going lower and sometimes to come back and rally. Part of high probability trading is not taking high-risk trades; jumping onboard too quickly before the direction is determined is dangerous. The best thing to do in these situations is to sit back, wait until the market picks a clear direction and the noise settles, and then jump onboard. I used to try to trade the initial spike, but I ended up getting hurt badly a few times, so now I wait. Once the market has picked its direction, there is still a lot of room to make money. Chart 4–5shows a great example of how the market faded the news after a Fed cut. At 2:15 (Point A) on March 20, 2001, the Fed announced that it would cut rates again. Though this was good news for the www.rasabourse.com

market, it was anticipated that the Fed would do what it did. The initial response in the first 15 minutes was a drop followed by a quick strong move up, but not much higher than where the market had been before the news. Soon afterward, the run-up failed to continue and the market started coming off again. At this point you have to start thinking that there was good news and the market couldn’t break higher even though it tried to. This would be the time to start thinking about shorting. Yes, a half hour has gone by, but now you have a clearer picture of what the market is doing. As soon as it breaks the lows it made right after the announcement (Point B), one should begin shorting. At that point the market has digested the news and picked its direction, and so one should forget the news and trade the market.

Don’t Marry a Fundamental Opinion One mistake that traders who focus too much on fundamentals can fall into is to get an opinion in their heads and stick with it even after the market turns. They may believe that the weather this year is the

CHART 4–5

1-Minute S&P 500: Trading the Market, Not the News

best it has been in years for harvesting corn. Due to the ideal weather, there should be a banner crop and corn prices should drop. Yet after a few weeks the price fails to drop even though the temperature and rainfall have remained perfect. The stubborn traders will stay with this position and even add to it because they have become set in their opinions. They ignore the fact that the market says, “Hey, look, prices are going up. Why don’t you buy it, moron?” They just keep looking at the forecasts and are convinced they are right, yet they ignore the fact that China has not had rain in 6 months and is buying all the grain in sight. When the market fails to do what it is supposed to do, there may be another factor driving it, and a trader can’t be stuck with an opinion if he plans to succeed.

I’ve seen too many traders get hurt as they fight the market when they are clearly wrong, believing the market should go the other way because of some fundamental reason. This happens a lot in the stock market. Someone buys a stock at $188 because the company makes a chip that will revolutionize the world and then holds the stock until it reaches $4 because he still believes they have a great product and are a solid company; at some point one has to realize one is wrong and join the right side of the market.

When the NASDAQmarket began to collapse in March 2000, many people refused to acknowledge it because they had the opinion that the economy was booming and that many of the tech and Internet companies they had invested in would keep going up nonstop. They failed to realize that these overvalued stocks would go back to being fairly priced when the economy slowed down. When the market started dropping and was clearly in a major downtrend, people stayed long because they were married to their opinion that their stocks would go higher. The drop in prices kept screaming that the market was no longer a strong market, but many people saw it as an opportunity to buy more at discount prices or hold on to their original positions because the market should have started to return to its strength. They were wrong and paid dearly for not changing their opinions.

CHANGING ONE’S OPINION It’s not easy to change an opinion based on fundamentals, which is why you must always get the whole picture and keep looking at the technicals driving the market. Achart won’t lie to you: It tells

you the market is going up, down, or sideways. If you are long a stock and the chart is not going higher or is pointing lower, whatever you thought would make it go up is not working anymore. Don’t fight it. It doesn’t pay; just get out and reevaluate. The method I use to change my opinion of the market when I’m starting to realize that I am wrong is to say to myself, “If I had no position on, which side would I like to be on?” Questioning myself makes it a little clearer that I should not be in that position anymore; the hard part is actually getting out of it.

LEARN TO BE OBJECTIVE When it comes to being objective about a fundamental idea remember to not think with your position. Two people can hear the same news and look at it completely differently because of their positions. Atypical example occurs when an economic number comes out that is good for the economy. Those who are long-biased will think, “Wow, the economy is doing great; this market will keep going up.” Those who are short will look at it and think, “Great, the economy is getting too strong; the Fed will not cut interest rates again, so the market should sell off.” The market can go either way in these situations. The market will tell you where it should go, and your opinion doesn’t mean anything to the market. By focusing on the market and not on the fundamentals, one can be more objective and have a better grasp of what is going on.

BECOMING A BETTER TRADER Becoming a better trader requires learning what to do with fundamental analysis and knowing how to trade the news. Start by getting a fundamental picture of the market. Whether you trade corn, pork bellies, Japanese yen, JPMorgan, or Microsoft, you should find out what is making it move in the direction it is moving. Look at the whole industry and any world events that may have an impact on your market or stock. If you can determine that corn is going higher because world production has been slow the last 2 years, you have a small advantage over many traders. You know that as long as the fundamentals don’t change, you are better off trading the market from the long side.

Another way to improve your trading is to confirm your fundamental opinion by looking at charts. If the corn chart is going up, you know that the fundamentals are working, but if it is flat or going down, you need to question it. Maybe there is something else driving the market, but whatever the case, don’t stay married to a trade if it is not confirmed in the charts. As a trader you must be willing to change your opinion often because the market never stays the same. Don’t get opinionated in a trade. If it doesn’t react the way you thought it would, get out and move on. Alot of traders fail because they hold on much too long if they believe the market has to move with the news.

As for breaking news and reports, don’t forget that the market already may have discounted them in its price. Don’t be surprised if once the news comes out, the market goes the other way as people “sell the facts.” When you are trading on the basis of news, don’t trade the news but trade the market’s reaction to it. Jumping into a trade on the basis of a news-related event is not a high probability trade; it’s more of a gamble than anything else. Instead, try to determine what should happen and then react according to what the market does. If it is good news and the market keeps going up, buy on a dip. If it is good news and the market doesn’t go up, I normally would short aggressively. If news is due to come out, set up different scenarios in advance of what should happen; that way you will be prepared to react no matter what happens.

The Problems of Trading the News

1. Trying to predict market’s response 2. Marrying a fundamental opinion 3. Losing objectiveness 4. Ignoring the market’s trend 5. Getting caught in a spike 6. Never being the first to know 7. Trading discounted news 8. Taking a gamble

How to Increase Your Chances with Fundamental Analysis

1. Get the whole picture. 2. Use fundamentals to determine what is driving the market. 3. Complement it by using technical analysis. 4. Get a long-term idea of where the market is going. 5. If it should go up and doesn’t, it’s going lower. 6. Don’t be afraid to fade the news. 7. Don’t jump into a trade as soon as the news comes out. 8. Let the market digest the news. 9. Don’t trade your opinion; trade the market. 10. Be able to change your opinion. 11. Buy the rumor, sell the fact. 12. Remember, bad news may be good for the market. 13. Don’t gamble: Be flat before a report.

Helpful Questions to Ask Yourself

If I had no position, which side would I like to be on? Which way should the market respond to this news? Did I give the market enough time to digest the news? Am I married to my opinion?

PART III